Currency swaps Definition A swap is a derivative contract equivalent to a bundle of forward contracts Swaps are designed to take advantage of the Quality

Currency swapsCurrency swaps

DefinitionDefinition

A swap is a derivative contract equivalent to a bundle of forward contracts

Swaps are designed to take advantage of the Quality Spread Differential - QSD

QSD arise whenever there is a comparative advantage situation

Exemplification: Alpine Ski

Alpine Ski Inc. is a Swiss manufacturer of sporting goods. It needs to borrow $2 m to buy supplies and raw material from the United States.

Southern Inc. is a U.S. manufacturer of electronic equipment. It needs to borrow SFR 2.8 m to buy electronic components from Switzerland.

Southern is relatively unknown in the Swiss market.

The two companies decide to use a dealer to enter a foreign currency swap.

One-year borrowing rates:

Switzerland (SFR) United States ($)

Alpine Ski Inc. 7.5% 9.875%

Southern Inc. 8.5% 10%

Note

Alpine has an absolute advantage at borrowing in either USA or Switzerland because it is better known

Alpine has a comparative advantage at borrowing at home

Southern has a comparative advantage at borrowing at home

QSD calculation

QSD = [8.5% - 7.5%] - [10% - 9.875%] = 0.875%

QSD = 87.5 basis points

Switzerland (SFR) United States ($)

Alpine Ski Inc. 7.5% 9.875%

Southern Inc. 8.5% 10%

Splitting the QSD

The 87.5 basis points have to be divided among Alpine, Southern, and the dealer.

The dealer is quoting the swap, hence it has more power over how the QSD is split

The onset

Swiss creditors US creditors

Dealer

AlpineSouthern

SFR2.8 m

at 7.5%

SFR2.8 m

SFR2.8 m

$2 m at 10%

$2 m

$2 m

Interest payments


Dealer

AlpineSouthern

SFR 0.21 m

$0.195 m

$0.2 m

$0.2 m

SFR 0.224 m

SFR 0.21 m

Repayment of the principal


Dealer

AlpineSouthern

SFR2.8 m

SFR2.8 m

SFR2.8 m

$2 m

$2 m

$2 m

Analysis

Alpine Ski Inc. borrows $2 m and pays $0.195 m in interest, that is 9.75%.

Southern Inc. borrows SFR2.8 m and pays SFR0.224 m in interest, that is 8%.

The dealer

Pays: - ($195,000 - $200.000) = $5,000

Receives: (SFR224,000 - SFR210,000) = SFR14,000

As long as e < SFR2.8/$ the dealer makes a net gain

Summary

Alpine

Southern

Dealer

Gets 12.5 basis points

Gets 50 basis points

Gets 25 basis points

Example 2Example 2

A US MNC desires to finance a capital expenditure of its German subsidiary. The project has an economic life of five years. The cost of the project is €40,000,000. The German subsidiary would be expected to earn enough on the project to meet the annual dollar debt service and to repay the principal in five years.

Assume a German MNC of equivalent creditworthness has a mirror-image financing need. It has a US subsidiary in need of $ 25,000,000 to finance capital expenditure with an economic life of five years. The US subsidiary would be expected to earn enough on the project to meet the annual dollar debt service and to repay the principal in five years.

Example 2Example 2

The two MNC face the following possible borrowing rates:

US capital marketborrowing rate

German capital marketborrowing rate

US MNC 8% 7%

German MNC 9% 6%

Borrowing alternativesBorrowing alternatives

today Year1 Year 2 Year 3 Year 4 Year 5

US MNC subsidiary in Germany: Cash flow (€) with swap

40 m -2.4 m -2.4 m -2.4 m -2.4 m -42.4 m

German MNC subsidiary in US: Cash flow ($) with swap

25 m -2 m -2 m -2 m -2 m -27 m

Contractual exchange rate (implied by the swap)

DM 1.6 DM 1.2 DM 1.2 DM 1.2 DM 1.2 DM 1.57

Exchange rate implied by international parity

DM 1.6 DM 1.57 DM 1.54

DM 1.51 DM 1.48 DM 1.46

US MNC subsidiary in Germany: Cash flow (DM) without the swap, if borrowing in Germany

40 m -2.8 m -2.8 m -2.8 m -2.8 m -42.8 m

US MNC subsidiary in Germany: Cash flow (DM) without the swap, if borrowing in the US

40 m -3.14 m -3.08 m -3.02 m -2.96 m -39.42 m

German MNC subsidiary in US: Cash flow ($) without the swap, if borrowing in the US

25 m -2.25 m -2.25 m -2.25 m -2.25 m -27.25 m

German MNC subsidiary in US: Cash flow ($), without the swap if borrowing in Germany

25 m - 1.53 m -1.56 m -1.59 m - 1.62 m -29.04 m



US MNC subsidiary in Germany: Cashflow (DM) with swap

40 m -2.4 m -2.4 m -2.4 m -2.4 m -42.4 m

German MNC subsidiary in US: Cash flow($) with swap

25 m -2 m -2 m -2 m -2 m -27 m

Contractual exchange rate (implied by theswap)

DM 1.6 DM 1.2 DM 1.2 DM 1.2 DM 1.2 DM 1.57

Exchange rate implied by internationalparity

DM 1.6 DM 1.57 DM 1.54 DM 1.51 DM 1.48 DM 1.46

US MNC subsidiary in Germany: Cashflow (DM) without the swap, if borrowingin Germany

40 m -2.8 m -2.8 m -2.8 m -2.8 m -42.8 m

US MNC subsidiary in Germany: Cashflow (DM) without the swap, if borrowingin the US

40 m -3.14 m -3.08 m -3.02 m -2.96 m -39.42 m

German MNC subsidiary in US: Cash flow($) without the swap, if borrowing in theUS

25 m -2.25 m -2.25 m -2.25 m -2.25 m -27.25 m

German MNC subsidiary in US: Cash flow($), without the swap if borrowing inGermany

25 m - 1.53 m -1.56 m -1.59 m - 1.62 m -29.04 m




40 m -2.4 m -2.4 m -2.4 m -2.4 m -42.4 m


25 m -2 m -2 m -2 m -2 m -27 m


€ 1.6 € 1.2 € 1.2 € 1.2 €1.2 € 1.57


DM 1.6 DM 1.57 DM 1.54

DM 1.51 DM 1.48 DM 1.46


40 m -2.8 m -2.8 m -2.8 m -2.8 m -42.8 m


40 m -3.14 m -3.08 m -3.02 m -2.96 m -39.42 m


25 m -2.25 m -2.25 m -2.25 m -2.25 m -27.25 m


25 m - 1.53 m -1.56 m -1.59 m - 1.62 m -29.04 m




40 m -2.4 m -2.4 m -2.4 m -2.4 m -42.4 m


25 m -2 m -2 m -2 m -2 m -27 m


€ 1.6 € 1.2 € 1.2 € 1.2 € 1.2 € 1.57


€ 1.6 € 1.57 € 1.54

€ 1.51 € 1.48 € 1.46


40 m -2.8 m -2.8 m -2.8 m -2.8 m -42.8 m


40 m -3.14 m -3.08 m -3.02 m -2.96 m -39.42 m


25 m -2.25 m -2.25 m -2.25 m -2.25 m -27.25 m


25 m - 1.53 m -1.56 m -1.59 m - 1.62 m -29.04 m




40 m -2.4 m -2.4 m -2.4 m -2.4 m -42.4 m


25 m -2 m -2 m -2 m -2 m -27 m


€ 1.6 € 1.2 € 1.2 € 1.2 € 1.2 € 1.57


€ 1.6 € 1.57 € 1.54

€ 1.51 € 1.48 € 1.46

US MNC subsidiary in Germany: Cash flow (€) without the swap, if borrowing in Germany

40 m -2.8 m -2.8 m -2.8 m -2.8 m -42.8 m

US MNC subsidiary in Germany: Cash flow (€) without the swap, if borrowing in the US

40 m -3.14 m -3.08 m -3.02 m -2.96 m -39.42 m


25 m -2.25 m -2.25 m -2.25 m -2.25 m -27.25 m


25 m - 1.53 m -1.56 m -1.59 m - 1.62 m -29.04 m

Analysis:Analysis:

For the US MNC subsidiary in Germany the borrowing alternatives are the following:

The swap:

Cost of borrowing: locked in at 6%

Borrowing in Germany:

Cost of borrowing locked in at 7%

Borrowing in the US:

Cost of borrowing variable, depends on exchange rate.

If international parity holds it should be 6.025%

Analysis:Analysis:

For the German MNC subsidiary in the US the borrowing alternatives are the following:

The swap:

Cost of borrowing: locked in at 8%

Borrowing in the US:

Cost of borrowing locked in at 9%

Borrowing in Germany:

Cost of borrowing variable, depends on exchange rate.

If international parity holds it should be 7.97%

DecisionDecision

Clearly, entering the swap reduces some of the uncertainty for both companies.

In the end, the borrowing decision will depend on how both parties will forecast future exchange rate movements.

Documents

Currency swaps Definition A swap is a derivative contract equivalent to a bundle of forward contracts Swaps are designed to take advantage of the Quality